At first glance, the American economy is healthy: We’ve had a year of full employment, wage increases and record corporate profits. Higher GDP growth is forecast for 2018.
Republicans, with their political monopoly in Washington and their agenda of tax cuts and deregulation, are claiming credit — no matter that they inherited a thriving economy in 2017. In fact, recent polls indicate that the economy is the one area in which President Donald Trump’s approval ratings are positive.
We don’t like to rain on the GOP’s party, but this episode of economic buoyancy cannot last. Trump and the Republican-dominated Congress are creating the conditions for a crisis that could prove as severe as the Great Recession of 2008-2010. But where the last crisis was “Made on Wall Street,” this one will bear the label “Made in Washington.”
[Analysis: Trump’s new problem: There’s growing talk of a downturn in 2019]
The most obvious folly is piling a massive federal spending increase, just enacted, on top of last year’s massive tax cuts. Together, these actions will escalate already fast-growing budget deficits. Deficits of nearly a trillion dollars at the peak of the business cycle mean that government borrowing in the coming years will drive up interest rates and “crowd out” business investments, new home construction and consumer spending on durable goods, which are keys to growth and prosperity. This squeeze on private capital formation will surely dampen — if not negate — the investment incentives in the Republicans’ new tax code.
In light of America’s pressing long-term challenges, we foresee a crisis down the road.
Large budget deficits under full employment are always irresponsible. The locked-in commitment to ongoing deficits will undercut our capacity to finance critically needed public investments in America’s deteriorating infrastructure and build human capital by investing in education and health. These are essential engines of sustained growth.
Large deficits as far as the eye can see will also multiply the challenges of funding Social Security and Medicare for an aging population as well as Medicaid for lower-income Americans. Budget experts know that America’s demographic trends are shaping a looming fiscal crisis. The heavy federal debt burden will make it even more painful.
In an added twist, the Federal Reserve is gradually selling off the trillions in government bonds it accumulated to stimulate recovery from the Great Recession. Largely because of swelling federal budget deficits, rising price inflation is now the consensus forecast. The Fed will likely respond by restricting growth in the money supply to curb inflationary pressures. Thus, in simple supply-and-demand terms, a flood of federal debt obligations on the bond markets will drive bond prices down and borrowing costs up. All borrowers will be vulnerable to credit rationing and rising interest rates.
[Opinion: America is set up for a fiscal disaster]
A final sobering effect of budget deficits is an inevitable increase in America’s trade deficit, despite the protectionist measures taking shape under the present administration. Through complex linkages, higher interest rates will make U.S. assets more attractive to foreign investors, which, in turn, will raise the value of the dollar and make U.S. goods less competitive. If the U.S. government borrows more from abroad, Trump’s import tariffs can have little impact on the trade deficit.
Rather, trade restrictions by the U.S. and other nations will be another factor depressing economic growth, by shrinking the gains we obtain from international trade and specializing in what we do best. The current tit-for-tat between the U.S. and China over tariffs could be the initial phase of a lose-lose trade war that could spread to more goods and services and to other U.S. trade partners
To the extent that America’s protectionist policies reduce the trade deficit, it will be because our partners reduce their U.S. government bond purchases, either in retaliation or, more likely, because protectionism makes the U.S. a less desirable destination for investment. The smaller the inflow of foreign capital to supplement domestic savings, the higher U.S. interest rates will be.
[Opinion: America owes its wealth to free trade. Throwing up trade barriers will only hurt us.]
We cannot predict when bond markets will reach a tipping point or whether the train wreck will be rapid or slow motion. But we are convinced that the government, under the Republican political monopoly, has created a ticking time bomb. Ultimately, current fiscal and international economic policies will cause a serious downturn, possibly rivaling the financial crisis that began 10 years ago.
A big difference from a decade ago: With a little economic common sense, we can see this one coming. With a huge budget deficit, federal revenues will shrink still further when the next recession hits, and the party in power will have no leverage to soften the blow by raising spending or cutting taxes.
Given today’s hyperpartisan political environment, that dire scenario seems highly likely.
David Vail is professor emeritus and Michael Jones associate professor emeritus in the Economics Department at Bowdoin College in Brunswick.
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